What Is Homemade Leverage?
Individual investors utilize homemade leverage to manipulate corporation leverage. Individuals investing in a firm without leverage can simulate the effect by employing homemade leverage, such as personal loans. However, company and individual tax rate disparities may hinder the investor’s leverage scenario construction.
How DIY Levers Work
The use of leverage raises investment risk and possible profits. Leveraged companies may provide a higher shareholder return, all else equal. Investment in leveraged corporations may be riskier than in non-leveraged enterprises.
An investor might avoid this risk/reward tradeoff by buying a firm’s shares without leverage and then using personal loans to obtain leverage. An investor in a non-leveraged firm can get a return closer to a leveraged company, provided they can borrow at the same rate as the company.
The investor wants to simulate corporate leverage’s return compounding in a non-leveraged organization. If an investor can borrow at the same rate as the firm, they may get close.
Special Considerations
According to the Modigliani-Miller theorem, investors disregard capital structure since they can easily erase changes with their leverage. Thus, a firm financial structure should not impact stock price.
The Modigliani-Miller theorem states that investors don’t care how a firm finances its investments (debt versus equity) or dividends. Because investors may replicate leverage in their portfolios. The theory suggests this only applies if taxes and bankruptcy costs are absent and the market is efficient.
Homemade Leverage Pros and Cons
Homemade leverage lets investors invest in an unleveled company to mimic a levered firm’s return. Taxes make it harder to calculate the leverage impact since corporate and individual leverage costs differ.
However, homemade leverage lets investors erase capital structure changes they don’t like. Suppose an investor-owned corporation raises debt. Companies might modify their portfolio leverage to retain leverage.
Conclusion
- Individuals can mimic corporate leverage with handmade leverage.
- The tax rate disparity between businesses and individuals makes corporate leverage hard to replicate.
- Because investors can employ DIY leverage, the Modigliani-Miller theorem argues that a company’s capital structure should not impact its stock price.
